Allocating Fixed Costs of Dual-Use Facilitiesby Exempt Organizat

Washington and Lee Law Review Volume 42 | Issue Article 16 Winter 1-1-1985 Allocating Fixed Costs of Dual-Use Facilities by Exempt Organizations: Actual Use or Availability for Use? Follow this and additional works at: https://scholarlycommons.law.wlu.edu/wlulr Part of the Organizations Law Commons, and the Tax Law Commons Recommended Citation Allocating Fixed Costs of Dual-Use Facilities by Exempt Organizations: Actual Use or Availability for Use?, 42 Wash & Lee L Rev 333 (1985), https://scholarlycommons.law.wlu.edu/wlulr/vol42/ iss1/16 This Note is brought to you for free and open access by the Washington and Lee Law Review at Washington & Lee University School of Law Scholarly Commons It has been accepted for inclusion in Washington and Lee Law Review by an authorized editor of Washington & Lee University School of Law Scholarly Commons For more information, please contact lawref@wlu.edu ALLOCATING FIXED COSTS OF DUAL-USE FACILITIES BY EXEMPT ORGANIZATIONS: ACTUAL USE OR AVAILABILITY FOR USE? The Internal Revenue Code of 1954 (Code) generally exempts certain nonprofit organizations from federal income taxation.' Section 501(c)(3) of the Code provides such an exemption for qualified educational organizations This tax-free status for educational organizations has remained virtually unchanged since the establishment of the first federal income tax in the United States Extending tax exemptions to educational organizations promotes the public welfare because qualifying education organizations provide instruction to the public on subjects useful to individuals and beneficial to the community The only important limitation upon the tax-free status of educational organizations is the Code provision taxing the unrelated business income of an other5 wise exempt organization See I.R.C § 501(c) fWest 1984) Organizations that § 501(c) exempts from federal income taxation include, among others, charitable organizations, educational institutions, scientific organizations, religious organizations, social welfare organizations, business leagues, social clubs, consumer cooperatives, labor unions, and trade associations Id Numerous qualifications, conditions, and exceptions apply to the general exemption from federal taxation for § 501(c) organizations See id §§ 501-08 (special rules apply to feeder corporations, private foundations, etc.) See generally Bittker & Rahdert, The Exemption of Nonprofit Organizationsfrom FederalIncome Taxation, 85 YALE L.J 299 (1976) (overview of relevant Code sections and analysis of justifications for allowing income tax exemptions for nonprofit organizations) I.R.C § 501(c)(3) (West 1984) Because § 501(c)(3) refers merely to "educational purposes," the proper definition of the word "educational" has been the subject of frequent litigation See J MERTENS, LAW OF FEDERAL INCOME TAXATION § 34.11 (1983 rev voI & Supp 1984) (overview of judicial interpretations of relevant Code and regulation sections defining "education") The Treasury Department regulations provide that § 501(c)(3) of the Code uses the term "educational" as relating to the "instruction of the public on subjects useful to the individual and beneficial to the community." Treas Reg § 1.501(c)(3)-1(d)(3)(i)(b) (1960) Although the regulations also provide examples of educational organizations, the Court of Appeals for the District of Columbia has held Treasury regulation § 1.501(c)(3)-1(d)(3), defining the term "educational," as unconstitutionally vague See Big Mama Rag, Inc v United States, 631 F.2d 1030, 1039-40 (D.C Cir 1980) (holding "full and fair exposition test" encompassed in regulation's definition of "education" was unconstitutionally vague); Treas Reg § 1.501(c)(3)-1(d)(3)(ii), T.D 6391, 1959-2 C.B 139, 144 (example of educational organizations include primary or secondary schools, colleges, trade schools, public discussion groups, correspondence schools, and museums) See generally J MERTENS, supra, § 34.11, at 75-76 (analysis of Big Mama Rag holding) See Rensselaer Polytechnic Institute v Commissioner, 732 F.2d 1058, 1060 (2d Cir 1984) (noting similarity between language of current and prior versions of § 501); see also Bittker & Rahdert, supra note 1, at 301-30 (background on legislative history of tax exemption for nonprofit organization) See Treas Reg § 1.501(c)(3)-1(d)(3)(i)(b), T.D 6391, 1959-2 C.B 139, 144; see also Bittker & Rahdert, supra note 1, at 334-35 (general discussion of justifications for exempting charitable and educational organizations) See I.R.C § 511 (a)(1) (West 1984) (tax imposed on unrelated business taxable income of § 501(c) organizations) Unrelated business taxable income is the gross income, less the directly WASHINGTON AND LEE LAW REVIEW [Vol 42:333 In 1950 Congress added the predecessor sections of 502 through 514 to the Code in response to well-publicized accounts of exempt organizations, particularly educational organizations, abusing their privileged status to generate otherwise fully taxable income in activities unrelated to their exempt function.' While the taxation of unrelated business income of exempt organizations is7 similar in theory to the computation of tax for ordinary business entities, the need to allocate the income and expenses between the exempt and unrelated activities greatly complicates the determination of the proper unrelated business tax liability.' The allocation is often tedious and controversial, especially when an exempt organization uses the same facility both for exempt purposes and for the production of unrelated business income., In Rensselaer Polytechnic Institute v Commissioner,10 the United States Court of Appeals for the Second connected allowable deductions from any regularly carried on trade or business, the conduct of which is not substantially related to the organization's exempt function Id § 512(a)(1); see Treas Reg § 1.512(a)-i, T.D 7392, 1976-1 C.B 162, 162-63 (provides more detailed definition of unrelated business taxable income); see also I.R.C § 513(a) (West 1984) (defines unrelated trade or business); Treas Reg § 1.513-1, T.D 6939, 1968-1 C.B 274, 275 (elaborating § 513 definition of unrelated trade or business) Revenue Act of 1950, ch 944, §§ 301, 331, 64 Stat 947, 957-58 (codified as amended at I.R.C §§ 502-14 (West 1984)); see Moore, Current Problems of Exempt Organizations, 24 TAx L REv 469, 469-74 (1969) (concise summary of legislative and judicial background of tax on unrelated business income) Prior to 1950, any unrelated income received by an exempt organization, regardless of the source of the income, was not taxable to the organization if the organization used the unrelated income to further the organization's exempt function See Trinidad v Sagrada Orden de Predicadores, 263 U.S 578, 581 (1924) (destination, not source, of income is dispositive test for taxability) Subsequent lower court decisions substantially expanded the destination-of-income test that the Supreme Court established in Trinidad See, e.g., Roche's Beach, Inc v Commissioner, 96 F.2d 776, 779 (2d Cir 1938) (profits from bathing beach business feeding a charitable organization not taxable); Sam Springs Home v Commissioner, B.T.A 198, 217 (1927) (income from greenhouse, cotton gin, and electric generating plant exempted from taxation); Appeal of Unity School of Christianity, B.T.A 61, 70 (1926) (religious organization's earnings from publications and inn income held exempt from taxation) The most notorious abuse of the tax exemption provided to charitable and educational organizations involved the acquisition of the nation's largest manufacturer of noodles for the benefit of the School of Law of New York University See C.F Mueller Co v Commissioner, 190 F.2d 120, 123 (3d Cir 1951) (tax-exempt status of feeder corporation upheld), rev'g 14 T.C 922 (1950) See generallyNote, The MacaroniMonopoly: The Developing Concept of Unrelated Business Income of Exempt Organizations,81 HARv L REv 1280 (1968) (overview and critique of tax on unrelated business income) [hereinafter cited as The Macaroni Monopoly] Sparked by the public reaction to the Mueller decision, Congress enacted the Revenue Act of 1950 to ease the concerns of private industry over unfair competition from exempt organizations See Moore, supra, at 470-71 (discussion of public and congressional reaction to Mueller); see also infra notes 89-92 and accompanying text (analysis of legislative history of Revenue Act of 1950) B BnTKER, FEDERAL TAXATION OF INCo E, ESTATES & GiFss 103.3 (1981 & Supp 1984) In computing the tax on unrelated business income, the term "taxable income" as used in § 11 of the Code, which imposes a tax on corporate taxable income, reads as "unrelated business taxable income." I.R.C § 511(a)(1) (West 1984) B BrrTKER, supra note 7, at 103.3 Id 10 732 F.2d 1058 (2d Cir 1984) 1985] ALLOCATING FIXED COSTS Circuit addressed this difficult allocation problem, by considering what constitutes a reasonable basis for allocating the fixed costs of a dual-use facility.' Rensselaer Polytechnic Institute (Rensselaer) is a tax-exempt educational organization incorporated under the laws of the State of New York.'2 Rensselaer owned and operated a fieldhouse used both for exempt purposes and for the production of unrelated business income.' Section 511 (a)(1) of the Code subjected the unrelated business income generated by the commercial use of the fieldhouse to taxation.' The Commissioner of Internal Revenue (Commissioner) contested the amount of deductible expenses taken from the unrelated business gross income by Rensselaer in computing its unrelated business taxable income for the taxable year ending in 1974.16 Rensselaer filed a petition with the United States Tax Court (Tax Court) for a redetermination of the Commissioner's assessment of a deficiency in the unrelated business tax due from Rensselaer.'" The Tax Court identified three types of deductible expenses related to the operation of the fieldhouse.18 Rensselaer's direct expenses, those specifically identified with particular commercial uses, were never in dispute and clearly were deductible.1 Additionally, the Tax Court considered the minor issue of Rensselaer's variable expenses, 20 those which varied in proportion to use but 11 Id at 1062 12 Rensselaer Polytechnic Institute v Commissioner, 79 T.C 967, 968 (1982) 13 Rensselaer, 732 F.2d at 1059 In Rensselaer Polytechnic Institute v Commissioner, the parties stipulated that the primary function of the fieldhouse was to carry out Rensselaer's educational responsibilities Rensselaer, 79 T.C at 968 Student uses of the facility included physical education, college ice hockey, student ice skating, intramurals, and commencement activities Id 14 Rensselaer,79 T.C at 968 In Rensselaer,the unrelated business uses of the fieldhouse included commercial ice shows and public ice skating Id 15 Rensselaer,732 F.2d at 1059; see I.R.C § 51 1(a)(1) (West 1984) (income from unrelated business activities is taxable) 16 Rensselaer, 79 T.C at 968 The Tax Court in Rensselaer noted that the parties stipulated all the material facts Id at 968 Consequently, no factual disputes were before the Second Circuit Rensselaer, 732 F.2d at 1059 Rensselaer's federal income tax period was on a fiscal year basis ending June 30, 1974 Rensselaer, 79 T.C at 968 17 Rensselaer, 79 T.C at 967 18 Id at 968-69 19 Id In Rensselaer,the direct expenses of the fieldhouse included costs specifically identified with various events, such as contract and labor costs attributable to a specific event Id at 969 n.5 The parties agreed that Rennselaer's direct expenses totalled $371,407 for the year ending in 1974 Id at 968-69 The parties did not dispute the deductibility of Rensselaer's direct expenses Id at 969; see I.R.C § 512(a)(1) (West 1984); Treas Reg § 1.512(a)-1(b), T.D 7392, 1976-1 C.B 162, 162-63 20 Rensselaer, 732 F.2d at 1060 The Second Circuit in Rensselaer noted that the Tax Court found that total variable expenses of the fieldhouse amounted to $197,210 allocable on a basis of actual use Id.; see Treas Reg § 1.512(a)-I(c), T.D 7392, 1976-1 C.B 162, 163 (requiring allocation of expenses from dual-use facilities on reasonable basis); see also, Kannry, How Hospitals Can Minimize Their PotentialExposure to the UnrelatedBusiness Income Tax, 43 J TAX'N 166, 168-69 (1975) (example of application of variable expense allocation) While the Commissioner approved of allocating variable expenses on a basis of actual use, the Commissioner contended that Rensselaer should have added certain adjustments to the total WASHINGTON AND LEE LA W REVIEW [Vol 42:333 which Rensselaer could not identify with specific events The dispute, however, centered primarily on Rensselaer's fixed expenses of operating the fieldhouse, which included those costs, such as depreciation and salaries, that did not vary in proportion to the use of the facility." Rensselaer asserted that the school legitimately could allocate fixed costs between the exempt educational use and the taxable commercial use on the basis of relative times of actual use for each purpose.23 Rensselaer thus sought to calculate the proportion of deductible fixed expenses by dividing the total number of hours the fieldhouse was in commercial use by the total number of hours the facility was in actual use for any activity.24 The Commissioner however, argued that the proper allocation basis was one of total time available for use, in which the25fractional denominator was the total number of hours in the taxable year The Tax Court reduced the deficiency asserted against Renesselaer, holding that allocations based on actual use were reasonable within the meaning of Treasury Department regulation section 1.512(a)-1(c) 26 The Commissioner hours of actual use, thus "increasing the denominator and reducing the portion of deductible expenses." Rensselaer, 79 T.C at 973; see infra notes 23-25 and accompanying text (definitions of actual-use and availability for use allocation methods) The Tax Court upheld only one minor adjustment, which neither party appealed Rensselaer, 79 T.C at 973; see Rensselaer, 732 F.2d at 1060 (neither side appealed Tax Court decision regarding amount of deductible variable expenses) 21 Rensselaer, 79 T.C at 969 n.6 22 Id The Second Circuit in Rensselaer noted that the stipulated fixed expenses were: Salaries and fringe benefits S 59,415 Depreciation 29,397 Repairs and replacements 14,031 Operating expenditures 1,356 $104,199 Rensselaer, 732 F.2d at 1060 23 Rensselaer, 732 F.2d at 1060 24 Id The college in Rensselaer would calculate the amount of fixed expenses properly deductible by multiplying the total amount of fixed expenses incurred by the percentage of unrelated business use to total actual use for all purposes Id 25 Id In allocating the expenses attributable to a dual-use facility, taxpayer has an incentive to allocate as much of the expenses as possible to the unrelated business usage to receive a tax benefit from expenses otherwise nondeductible by an exempt organization See id at 1065 (Mansfield, J., dissenting) (noting similar incentive in home office expense allocations) By using the total number of hours in the taxable year rather than the total hours the facility actually was in use as the denominator, the Commissioner's availability for use allocation method effectively reduced the portion of expenses deductible by the college in Rensselaer Rensselaer, 79 T.C at 973 The Second Circuit noted that the difference in tax liability between allocations based on actual use and availability for use in Rensselaer amounted to only $9,259 Rensselaer, 732 F.2d at 1060 Although the actual liability at stake in Rensselaer was minimal, the potential precedential value of this case of first impression did not go unnoticed See id at 1059 (amicus curiae briefs filed by American Council on Education, National Institute of Independent Colleges and Universities, and Yale University suggest importance of Rensselaer decision) 26 Rensselaer, 70 T.C at 974; see Treas Reg § 1.512(a)-1(c), T.D 7392, 1976-1 C.B 162, 163 (educational organizations must allocate expenses attributable to dual-use facility between the exempt and non-exempt uses on "reasonable basis") 1985] ALLOCATING FIXED COSTS appealed the Tax Court decision to the Second Circuit,27 asserting that allocations based on actual use fail to meet the statutory requirement that deductible expenses must be "directly connected with" the unrelated business activity The Commissioner criticized the analogy the Tax Court drew between dualuse facility allocations and home office expense allocations 29 The Commissioner also argued that the "directly connected with" language in section 512 of the Code requires a narrow interpretation to prevent exempt organizations from abusing their privilege The Second Circuit nevertheless rejected the Commissioner's arguments and affirmed the Tax Court decision In Rensselaer, the Second Circuit traced the historical origins of the tax on unrelated business income and carefully reviewed the applicable statute and regulations.32 On the basis of this analysis, the Rensselaer court rejected the Commissioner's assertion that actual-use allocations result in expenses not directly connected with the unrelated business activity.3 The Second Circuit stated that the Commissioner's position was contrary to both the underlying legislative intent in taxing unrelated business income and the applicable Treasury regulations 34 By taxing unrelated business income, Congress primarily sought to achieve parity between exempt and non-exempt organizations engaged in similar commercial activities without jeopardizing the basic purpose of the tax exemption.33 The Second Circuit stated that allocations based on availability for use failed to promote this type of equality between exempt and non-exempt organizations The Rensselaer court interpreted the Treasury regulations as providing that, when allocated on a "reasonable basis," the expenses of a facility used for both exempt and commercial purposes are "proximately and 27 Rensselaer, 732 F.2d at 1060 Either the Commissioner or the taxpayer may appeal a decision of the Tax Court to the appropriate United States Court of Appeals I.R.C § 7482(a) (West 1984) Because Rensselaer was a New York corporation, proper venue for an appeal rested in the Second Circuit See id § 7482(b)(l)(B) (for redetermination of corporate tax liability, venue lies in circuit of principal place of business of corporation) 28 Rensselaer, 732 F.2d at 1060 In Rensselaer, the Commissioner relied on § 512(a)(1) of the Code, which requires that deductible expenses by directly connected with the unrelated business activity Id passim; see I.R.C § 512(a)(1) (West 1984) (defining unrelated business income as gross income from unrelated business activities less allowable deductions directly connected with unrelated activities) 29 Rensselaer, 732 F.2d at 1060-62; see infra notes 66-81 and accompanying text (analysis of home office expense cases) 30 Rensselaer, 732 F.2d at 1060-61; see infra notes 50-58 and accompanying text (analysis of § 512 znd applicable regulations) 31 Rensselaer, 732 F.2d at 1062 (2d Cir 1984), aff'g 79 T.C 967 (1982) 32 Rensselaer, 732 F.2d at 1060-61; see supra note and accompanying text (discussion of historical origins of tax on unrelated business income) 33 Rensselaer, 732 F.2d 1061-62; see infra notes 48-58 and accompanying text (explaining that Commissioner's position ignores clear and unambiguous statutory and regulatory language) 34 Rensselaer, 732 F.2d at 1061; see infranotes 88-97 and accompanying text (availability for use allocations inconsistent with legislative intent to achieve parity between exempt and nonexempt organizations) 35 See Rensselaer, 732 F.2d at 1061 (summary of legislative intent of unrelated business income tax) 36 Id at 1062 [Vol 42:333 WASHINGTON AND LEE LA W REVIEW primarily related" to the commercial activity and, therefore, are directly connected with the unrelated business activity 37 The regulations, therefore, make such expenses expressly deductible 38 Like the Tax Court, the Second Circuit also found the home office expense cases analogous to Rensselaer, a case of first impression; 39 and deferring to the Tax Court's expertise in the applicaCourt's tion of the tax laws, 4" the Second Circuit found no error in the Tax decision that Rensselaer's method of allocation was reasonable' Conversely, the dissent in Rensselaer primarily argued that the fundamental 37 Id at 1061 As the Second Circuit noted in Rensselaer, § 512 of the Code defines unrelated business income as: the gross income derived by any [tax-exempt] organization from any unrelated trade or business regularly carried on by it, less the deductions allowed which are directly connected with the carrying on of such trade or business I.R.C § 512(a)(1) (West 1984); see Rensselaer, 732 F.2d at 1061 (noting definition of unrelated business income under § 512) The applicable regulations further provide that: [t]o be deductible in computing unrelated business taxable income , expenses, depreciation, and similar items not only must qualify as deductions allowed by chapter I of the Code, but also must be directly connected with the carrying on of the unrelated trade or business [with the phrase] to be 'directly connected with' [meaning] an item of deduction must have proximate and primary relationship to the carrying on of that business Treas Reg § 1.512(a)-l(a), T.D 7392; 1976-1 C.B 162, 162 A subsequent subsection of the same regulation provides: (c) Dual use offacilitiesorpersonnel.Where facilities are used both to carry on exempt activities and to conduct unrelated trade or business activities, expenses, depreciation and similar items attributable to such facilities (as, for example, items of overhead), shall be allocatedbetween the two uses on a reasonablebasis Similarly, where personnel are used both to carry on exempt activities and to conduct unrelated trade or business activities, expenses and similar items attributable to such personnel (as, for example, items of salary) shall be allocated between the two uses on a reasonable basis The portion of any such items so allocated to the unrelated trade or business activity is proximately and primarilyrelated to that business activity, and shall be allowable as a deduction in computing unrelatedbusiness taxable income in the manner and to the extent permitted by section 162, section 167 or other relevant provisions of the Code Id § 1.512(a)-l(c), T.D 7392, 1976-1 C.B 162, 163 (emphasis added) Overhead and personnel expenses are ordinary and necessary business expenses and are therefore allowable deductions pursuant to § 162 of chapter I of the Code I.R.C § 162 (West 1984) Likewise, depreciation deductions are allowable under § 167 of chapter of the Code Id § 167; see Kannry, supra note 20, at 168-69 (example of application of Treas Reg § 1.512(a)-I) 38 Treas Reg § 1.512(a)-I, T.D 7392, 1976-1 C.B 162, 162-63 39 Rensselaer, 732 F.2d at 1062; see infra notes 66-81 and accompanying text (analysis of home office expense cases) 40 Rensselaer, 732 F.2d at 1061 The Second Circuit in Rensselaer noted that appellate courts should not review the Tax Court's interpretation of the tax law unmindful of the Tax Court's expertise in these matters Id.; see ABKCO Indus Inc v Commissioner, 482 F.2d 150, 155 (3d Cir 1973) (affirming Tax Court interpretation of tax consequences of alleged royalties contract) Courts properly may attach weight to legal decisions made by administrative bodies having special competence to deal with the subject matter See Dobson v Commissioner, 320 U.S 489, 502 (1943) (appellate courts should give due regard to special competence of Tax Court) Tax Court resolutions of questions of tax law thus warrant deference and appellate courts should follow Tax Court decisions whenever possible ABKCO Indus., 482 F.2d at 155 41 Rensselaer, 732 F.2d at 1061-62 1985] ALLOCATING FIXED COSTS differences between exempt and taxable entities required a stricter standard of deductibility for exempt organizations with unrelated business income than for taxable organizations The dissent contrasted the Treasury regulation governing expense deductions for profit-seeking entities with the narrower regulations governing unrelated business income The dissent also questioned the validity of using the home office expense cases as evidence of the reasonableness of actual-use allocations, in light of the Ninth Circuit's reversal of an actual-use allocation in a home office expense case." The dissent found precedent for its proposition that actual-use allocations improperly resulted in expenses not directly connected with the unrelated business activity in Pittsburgh Press Club v United States." In PittsburghPress Club, the Third Circuit determined a social club's unrelated business income by considering deductible only those expenses that the club would not have incurred but for the unrelated business activity." The Rensselaer court, in affirming the Tax Court decision, however, distinguished PittsburghPress Club by noting that that case involved the possible revocation of the club's tax-exempt status for engaging in outside business activities proscribed by the Code as opposed to unrelated business income that an exempt educational organization may earn 47 permissibly 42 Id at 1063-64 (Mansfield, J., dissenting) 43 Id at 1064-65; see Treas Reg § 1.162-1(a), T.D 6291, 1958-1 C.B 63-64 (ordinary and necessary expenses directly connected with profit-seeking business are deductible); id § 1.512(a)-l(a), T.D 7392, 1976-1 C.B 162, 162 (unrelated business expenses must be directly connected with unrelated activity and otherwise qualify as deductions); see also infra note 56 (comparison of conjunctive and disjunctive language in unrelated business income and deductible business expense regulations) 44 Id at 1065-66; see infra notes 75-78 and accompanying text (analysis of Ninth Circuit's reversal of Tax Court's approval of actual-use allocations of home office expenses) 45 Rensselaer, 732 F.2d at 1066 (Mansfield, J., dissenting); see Pittsburgh Press Club v United States, 579 F.2d 751 (3d Cir.), on remand, 462 F Supp 322 (W.D Pa 1978), rev'd, 615 F.2d 600 (3d Cir 1980) 46 Id at 761 In Pittsburgh Press Club v United States, the Third Circuit noted that following an extensive audit the Internal Revenue Service revoked the club's exempt status and assessed income taxes on club revenues for subsequent taxable years Id at 753 The Internal Revenue Service asserted that the club's continued practice of renting its facilities for outside affairs resulted in the receipt of substantial revenues from outside sources Id This practice constituted engaging in business in violation of § 501(c)(7) of the Code, which requires a social club to operate exclusively for nonprofit purposes Id at 753-54; see I.R.C § 501(c)(7) (West 1984) (exempt social clubs prohibited from engaging in outside business activities) 47 Rensselaer,732 F.2d at 1062 In distinguishing PittsburghPress Club, the Second Circuit in Rensselaer noted that § 501(c)(7) of the Code prohibits an exempt social club from engaging in any outside business activity Id.; see I.R.C § 501(c)(7) (West 1984) (substantially all activities of social clubs must be for pleasure, recreation, and other nonprofitable purposes); Treas Reg § 1.501(c)(7)-1(b) (1958) (clubs engaging in business, such as making their facilities available for public rental, are not exempt from taxation under § 501(a)); see also supra note 46 (discussion of Commissioner's position in PittsburghPress Club) In fact, the only outside profits permitted under § 501(c)(7) of the Code are those profits strictly incidental to the club's activities and that are either negligible or nonrecurring See United States v Fort Worth Club of Fort Worth, Texas, 345 F.2d 52, 57-58 (5th Cir.) (rental income deemed substantial and profitable business and not WASHINGTON AND LEE LAW REVIEW [Vol 42:333 The Second Circuit in Rensselaer correctly noted that the Commissioner ignored his own definition of the concept of "directly connected with" included in the regulations 48 By expressly including depreciation, personnel expenses, and overhead, the Treasury regulation pertaining to exempt organizations' dual use of facilities or personnel is directly applicable to all the fixed expenses related to Renssalaer's fieldhouse Although the Code and Treasury regula- tions require a narrow interpretation of what constitutes a deductible expense for an exempt organization," the dual-use regulation explicitly states that the portion of fixed expenses allocated on a reasonable basis is proximately and primarily related to the unrelated business activity 5' In turn, regulation sec- tion 1.512(a)-l(a) defines the concept "directly connected with" as requiring an item of deduction to have a proximate and primary relationship to the conduct of the unrelated business activity.12 Reasonably allocated fixed expenses, consequently, have the requisite direct connection with the unrelated business activity." In an administrative ruling prior to Rensselaer, the Internal Revenue Service reached the identical conclusion.54 The Commissioner and the dissent in Rensselaer ardently strived to avoid giving section 512 and the applicable regulations their natural reading.5 Nevertheless, the distinction drawn between the deductibility requirements of exempt organizations and profit-seeking businesses,56 as well as, the dissent's statutory construction permissibly derived from club's social activities or services usually provided to members), modified and aff'd on rehearing, 348 F.2d 891 (5th Cir 1965) In PittsburghPreys Club, the Third Circuit held that when measuring the amount of outside profits allowable under § 501(c)(7), a social club may not reduce its net profit by costs that the club would not have incurred but for the unrelated business activity 579 F.2d at 761-62 The PittsburghPressClub court explicitly limited its holding to situations in which courts inquire into the propriety of the revocation of a social club's exemption Id at 762 48 See Rensselaer, 732 F.2d at 1062 49 See Treas Reg § 1.512(a)-1(c), T.D 7392, 1976-1 C.B 162, 163; supra note 22 (list of fixed expenses related to Rensselaer's fieldhouse) 50 See I.R.C § 512(a)(1) (West 1984) (expenses must be otherwise deductible and directly connected with the unrelated business activity); Treas Reg § 1.512(a)-l(a), T.D 7392, 1976-1 C.B 162, 162 (same) 51 Treas Reg § 1.512(a)-l(c), T.D 7392, 1976-1 C.B 162, 163 52 Treas Reg § 1.512(a)-l(a), T.D 7392, 1976-1 C.B 162, 162 53 See id § 1.512(a)-l(a), (c), T.D 7392, 1976-1 C.B 162, 162-63 (direct connection of reasonably allocated fixed expenses follows from complete reading of relevant regulations) 54 See Rev Rul 76-402, 1976-2 C.B 177, 178 (summer tennis camp's use of exempt school's facilities resulted in dual use of facilities, with allocable portion of expenses deductible in computing unrelated business taxable income) 55 See Rensselaer,732 F.2d at 1064-65 (Mansfield, J., dissenting) (discussing, with approval, Commissioner's position) 56 Id The Rensselaer dissent contrasted the disjunctive language in the regulation governing business deductions for profit-seeking organizations with the conjunctive wording in the regulation relating to the tax on unrelated business income Id Compare Treas Reg § 1.162-1(a), T.D 6291, 1958-1 C.B 63.64 (expenses deductible by profit-seeking organizations include ordinary and necessary expenditures directly connected with or pertaining to taxpayer's business) with Treas Reg § 1.512(a)-1(a), T.D 7392, 1976-1 C.B 162, 162 (expenses not only must qualify as deductions allowed by chapter I of Code, but also must be directly connected with unrelated business activity) ALLOCATING FIXED COSTS 1985] argument57 fails in light of the clear and unambiguous language of the statute and regulations Accordingly, the dispositive issue in Rensselaer, as the Second Circuit noted, was whether the college's actual-use allocation method was reasonable Taxpayers determine their income for tax purposes according to the regular method of accounting used in keeping their financial books.6" Taxpayers, furthermore, have the discretion to choose the methods best adapted to their requirements, as long as the method clearly reflects taxable income ' Availability for use and actual-use allocations are differing accounting methods analogous to straight-line and service-hours depreciation methods, respectively 62 Like their theoretical equivalents, allocations of the fixed costs of a dual-use facility based on both availability for use and actual use may clearly reflect income in a given fact situation 63 In Rensselaer, the Commissioner did not claim that the college's allocation method was unreasonable as applied to the facts."' Accordingly, nothing prohibited Rensselaer from exercising its discretion in choosing actual-use allocation as its accounting 65 method Both the Tax Court and the Second Circuit analogized the Rensselaer facts to the home office expense cases 66 The rationales used in allocating home 57 Rensselaer, 732 F.2d at 1065 (Mansfield, J., dissenting) The dissent in Rensselaerimplied that the more general provision of Treas Reg § 1.512(a)-l(a) somehow negates the more specific provision in subsection (c), which permits allocations of expenses on a reasonable basis Id.; see Treas Reg § 1.512(a)-l(c), T.D 7392, 1976-1 C.B 162, 163 58 See Ernst & Ernst v Hochfelder, 425 U.S 185, 200-01, 214 (1976) (statutory language controls if sufficiently clear in this context); see also Commissioner v Portland Cement Co., 450 U.S 156, 169 (1981) (Treasury regulations sustained unless unreasonable and plainly inconsistent with Code); Commissioner v South Texas Lumber Co., 333 U.S 496, 501 (1948) (Treasury regulations overruled only for significant reasons) 59 Rensselaer, 732 F.2d at 1061; see Treas Reg § 1.512(a)-i(c), T.D 7392, 1976-1 C.B 162, 163 (mandating allocation of dual-use expenses on reasonable basis) 60 See I.R.C § 446(a) (West 1984) (taxable income computed under taxpayer's method of accounting unless such method does not clearly reflect income); Treas Reg § 1.446-1(a)-(I) & (2) T.D 6282, 1958-1 C.B 215, 217 (same) 61 See I.R.C § 446(b) (West 1984) (taxpayer has discretion to choose accounting method that clearly reflects income); Treas Reg § 1.446-1(1) & (2), T.D 6282, 1958-1 C.B 215, 217 (same) 62 Cf Rensselaer, 732 F.2d at 1065 n.3 (Mansfield, J., dissenting) (analyzing depreciation methods to argue majority decision improperly allowed expense deductions when fieldhouse was not in commercial use) Straight-line depreciation is a function of the passage of time and is conceptually most accurate when the availability of the asset is more important than the actual use of the asset E SPLLER, FiNArciA AccourNrnN 276 (1971) Conversely, service-hours depreciation is a function of actual usage in a period relative to projected total usage and is more appropriate when physical use is the most important factor in the determination of an asset's useful life Id at 278 63 Compare I.R.C § 280A(c)(4)(C) (West 1984) (availability for use used in allocations of home day care center facilities) with id § 280A(e)(1) (actual-use allocation used for rental vacation homes) 64 Rensselaer, 732 F.2d at 1062 65 See supra note 61 and accompanying text (taxpayer has discretion over choice of accounting methods if such methods clearly reflect income) 66 See Rensselaer, 732 F.2d at 1062; Rensselaer, 70 T.C at 970-72; see also infra note WASHINGTON AND LEE LAW REVIEW [Vol 42:333 office expenses between business and personal use are helpful in judging the reasonableness of actual-use allocations in the unrelated business income context 67 Even the Rensselaer dissent agreed that the home office allocations are somewhat comparable to the allocations required of exempt organizations engaged in unrelated business activities 68 Prior to the enactment of the Tax Reform Act of 1976, 6' home office expenses were deductible even though the business use of that portion of the house was not exclusive.7" Taxpayers thus had to allocate the home office expenses between the deductible business and nondeductible personal use.7" The Tax Court's approval of taxpayers allocating the home office expenses on the more beneficial actual-use basis remained unchallenged until Gino v Commissioner.72 In Gino, the Tax Court set out the rationale of the preceding home office expense -case: that allocation of home office expenses on an actual-use basis more clearly reflects the proper 73 business deductions allowed than allocations based on availability for use The Tax Court reasoned that allocations based on availability for use rest on the erroneous and misleading assumption that the portion of the house used for dual purposes, when idle, is not equally available for either business or personal use.74 Nevertheless, the Ninth Circuit in Gino reversed the Tax Court decision 75 Noting that the regulation proscribing deductions of per- sonal expenses did not specify how to allocate expenses attributable to 70 (list of home office expense cases) 67 Rensselear, 732 F.2d at 1065 (Mansfield, J., dissenting) With both home office expense and unrelated business income allocations, an incentive exists to allocate as much of the expenses as possible to the taxable activity Id.; see supranote 25 (incentive to reduce tax liability and receive tax benefit for otherwise nondeductible expenses) 68 Rensselaer, 732 F.2d at 1065 (Mansfield, J., dissenting) 69 Pub L No 94-455, 90 Stat 1520 (1976) (codified as amended in scattered sections of 26 U.S.C.) 70 See, e.g., Browne v Commissioner, 73 T.C 723, 728-29 (1980) (self-employed taxpayer performed craft work, painting, medical and legal transcribing, and tax return preparation in portion of house); Gino v Commissioner, 60 T.C 304, 313-15 (1973) (taxpayers were high school teachers who performed nonclassroom duties at home), rev'd, 538 F.2d 833 (9th Cir.), cert denied, 429 U.S 979 (1976); International Artists, Ltd v Commissioner, 55 T.C 94, 107-08 (1970) (proportionate cost of home office and studio deductible by self-employed entertainer) See generally Halperin, BusinessDeductionfor PersonalLiving Expenses: A Uniform Approach to an Unsolved Problem, 122 U PA L REv 859, 912-15 (1974) (analysis of home office expenses in context of general nondeductibility of personal expenses) 71 See I.R.C § 262 (West 1984) (personal expenses not deductible); id § 162 (ordinary and necessary business expenses generally deductible) The expenses related to the portion of the house used as an office are deductible See id The expenses involved in maintaining a personal residence, however, are generally nondeductible personal expenses See id § 262 72 538 F.2d 833 (9th Cir 1976), rev'g 60 T.C 304 (1973), cert denied, 429 U.S 979 (1976) 73 See Gino, 60 T.C at 315 (availability of use allocations based on erroneous assumption) 74 Id As homeowner, the taxpayer may choose to use a portion of his house at his discretion for either business or personal reasons Id If the facility was equally available at all times for both uses, a taxpayer may allocate reasonably a portion of the fixed expenses of the facility, while not in use, should be allocated to both purposes Cf Browne v Commissioner, 73 T.C 723, 730 (1980) (Hall, J., concurring) (no statutory warrant for applying more severe proration test for qualifying home office expenses than for expenses of any other dual-use facility) 75 Gino, 538 F.2d at 835 19851 ALLOCATING FIXED COSTS deductible home office expenses, the Ninth Circuit deferred to a revenue ruling that illustrated and applied the Internal Revenue Service's availability for use allocation method 77 While the Ninth Circuit did reverse the Tax Court's approval of actual-use allocations in Gino, it was the only circuit to so rule.7 The Tax Court also specifically reaffirmed its position in Browne v Commissioner" holding that the fraction applicable to allocating home office expenses was the total time the taxpayer used her home for business divided by the time the taxpayer actually used the space for all purposes."0 As the concurring opinion in Browne noted, the Ninth Circuit did not base its reversal in Gino on the merits of availability for use allocation, but rather on administrative deference to a revenue ruling.' Since Browne, the addition to the Code of section 280A with its exclusivity requirement effectively has preempted any further judicial development of the allocation issue for home 82 office expenses In addition to questioning the validity of the home office expense analogy following the Ninth Circuit's decision in Gino, the dissent in Rensselaer argued that the analogy was flawed because a homeowner could use his home for any purpose he chooses while an exempt educational organization must dedicate its facilities to exempt purposes, undercutting the reasonableness in allocating idle time proportionally.8 The dissent's argument, however, fails to recognize that an educational organization does not jeopardize its exempt status if the organization uses some facilities for dual purposes.8 Under dual usage, a 76 See Treas Reg § 1.262-1(b)(3), T.D 6313, 1958-2 C.B 113, 115 (portion of expenses properly attributable to business is deductible as business expense) 77 Gino, 538 F.2d at 835; see Rev Rul 62-180, 1962-2 C.B 52 (Example illustrates computation of allowable deduction for portion of expenses attributable to business use of home) 78 See Gino, 538 F.2d at 835 79 Gino, 73 T.C 723, 728-29 (1980) 80 Id 81 Id at 730-31 (Hall, J., concurring) The concurring opinion in Browne v Commissioner expressly refused to uphold the Commissioner's position on availability for use allocations, even though an existing revenue ruling outlined that position Id A revenue ruling is merely the legal opinion of an Internal Revenue Service attorney and lacks the force or effect of law See, e.g., Bartels v Birmingham, 332 U.S 126, 132 (1947) (interpretative rulings of Treasury regulations regarding definition of independent contractors for social security tax purposes ignored); Idaho Power Co v Commissioner, 477 F.2d 688, 696 n.10 (9th Cir 1973) (revenue ruling on nondeductibility of depreciation on equipment owned by taxpayer and used in self-construction of capital improvements deemed in conflict with revenue statutes and, therefore, was without any force), rev'd on other grounds, 418 U.S (1974); Stubbs, Overbeck & Assocs., Inc v United States, 445 F.2d 1142, 1146-47 (5th Cir 1971) (ignoring revenue ruling defining per diem living allowances at remote job site as wages for income tax withholding purposes) 82 I.R.C § 280A (c) (West 1984) Section 280A(c) limits allowable deductions for home office expenses to those portions of the home used exclusively and on a regular basis for business purposes Id Section 280A(c), therefore, eliminated the need to allocate expenses between the dual uses See id 83 Rensselaer, 732 F.2d at 1065-66 (Mansfield, J., dissenting) 84 Id at 1065 85 See Trinidad v Sagrada Orden de Predicadores, 263 U.S 578, 581 (1924) (entity organized WASHINGTON AND LEE LAW REVIEW [Vol 42:333 facility's idle time arguably is equally available for both exempt and commercial activities An educational institution, therefore, reasonably could allocate fixed expenses during idle time in proportion to the actual use of the facility.' Allocating the fixed expenses of a dual-use facility on the basis of actual use would better effectuate the legislative purpose of taxing unrelated business income While the general purpose of the Revenue Act of 1950 was to raise revenues, 89 the legislative history indicates that Congress had a more specific intent in enacting the provisions regarding the tax on unrelated business income.90 Congress sought to eliminate the unfair competitive advantage exempt organizations enjoyed over their profit-seeking counterparts9' and to achieve and operated exclusively for religious, charitable, scientific, or educational purposes still may have net income); C.F Mueller Co v Commissioner, 190 F.2d 120, 122 (3d Cir 1951) (upholding exemption for feeder corporation generating business income unrelated to educational function of donee) See generally Eliasberg, Charity and Commerce: Section 501(c)(3)-How Much Unrelated Business Activity?, 21 TAx L R~v 53 (1965) (overview of separation of qualification for exemption and taxation of unrelated business income); J MERTENS, supra note 2, § 34.07, at 35-36 (judicial interpretations of "exclusively" have allowed some activities not directly furthering organization's exempt function) 86 But cf Rensselaer, 732 F.2d at 1065 (Mansfield, J., dissenting) (court cannot reasonably assume that fieldhouse's idle time was equally available because Rensselaer would not have received its exemption in first place) See supra note 85 and accompanying text (exempt organizations allowed some unrelated activities without risking loss of exemption) 87 Cf supra note 67-68 & 74 and accompanying text (unrelated business income allocations analogous to home office expense allocations) 88 Cf., Rensselaer, 732 F.2d at 1062 (Commissioner's interpretation of § 512 does not fulfill congressional intent in passing statute) 89 See H.R REP No 2319, 81st Cong., 2d Sess (1950) reprinted in 1950-2 C.B 380, 380 (1950) [hereinafter cited as H.R REP No 2319] The House Ways and Means Committee stated that the various revenue raising provisions in their Revenue Act of 1950 tax bill were to recoup partially the loss from the substantial reductions in war excise taxes Id The bill included changes in the tax treatment of charitable and educational organizations as one of the revenue raising provisions Id at 381 After the House passed its version of the bill, substantial increases in defense expenditures related to the United States' military involvement in Korea compelled the Senate to convert the excise tax reduction bill into a revenue producing measure See S REP No 2375, 81st Cong., 2d Sess 28 (1950) reprinted in 1950-2 C.B 483, 484 (1950) 90 See infra notes 91-92 and accompanying text (primary purpose for imposition of tax on unrelated business income was elimination of unfair competition and inequity in tax system); See also Louisiana Credit Union League v United States, 693 F.2d 525, 539-41 (5th Cir 1982) (discussion of history of 1950 tax legislation); Veterans' Found v United States, 281 F.2d 912, 913-14 (10th Cir 1960) (same); United States v Community Serv Inc., 189 F.2d 421, 425-27 (4th Cir 1951) (same) 91 See H.R REP No 2319, supra note 89, reprintedin 1950-2 C.B at 409 (1950) (unrelated business tax provisions primarily directed at problem of unfair competition); Treas Reg § 1.513-1(b), T.D 6939, 1968-1 C.B 274, 275 (same); see also Comment, Colleges, Charities,and the Revenue Act of 1950, 60 YALE L.J 851, 875 (1951) (primary purpose of unrelated business tax was elimination of unfair competition between taxable and tax-exempt businesses) The specific competitive advantage possessed by an exempt business is a higher rate of return on the business' capital, which allows the exempt business to expand operations and compete more effectively against nonexempt businesses See The MacaroniMonopoly, supra note 6, at 1281-82 See generally Bittker & Rahdert, supra note 1, at 318-20 (critical analysis of alleged competitive threat posed by exempt organizations) 19851 ALLOCATING FIXED COSTS equity in the tax system by closing the loophole that allowed exempt organizations to engage in otherwise taxable activities at no tax cost.92 While both allocation methods eliminate the inherent inequity that previously existed in the Code, only actual-use allocations encourage the achievement of parity between exempt and non-exempt organizations engaged in similar commercial endeavors.9 Actual-use allocations distribute a ratable share of the fixed costs to those periods when the facility is not in use.9 This distribution mirrors the treatment the Code allows to non-exempt businesses.95 Conversely, under availability for use allocations, an exempt organization could not allocate any of its fixed costs to the facility's idle time.9 Rather than achieving parity, therefore, availability for use allocations would place exempt organizations at a competitive disadvantage with its non-exempt counterparts In affirming the Tax Court decision, the Second Circuit properly held that Rensselaer's method of allocating the fixed expenses of its fieldhouse was reasonable within the meaning of the applicable regulations.' Allocations based on actual use satisfy the regulatory requirement of allocation on a reasonable basis99 and fulfill the legislative intent of the unrelated business income tax provisions of the Code 100 Moreover, with general public policy providing privileged status to educational organizations, preference should go to the allocation method that is more beneficial to the exempt institution when choosing between two reasonable accounting methods The approval of allocating the fixed costs of a dual-use facility on an actual-use basis could have a beneficial impact nationwide on all organizations exempt from federal income taxation by section 501(c)(3).'' With the increasing difficulty that educational 92 See Treas Reg § 1.513-1(c), T.D 6939, 1968-1 C.B 274, 275 (purpose of unrelated business tax was to place exempt organization commercial activities on same tax basis as taxable organizations); 96 Cong Rec 769, 770 (1950) (President Truman's message to Congress regarding Revenue Act of 1950 stressed need to improve equity in tax system by closing certain loopholes) 93 See infra notes 96-97 and accompanying text (availability for use allocations place exempt organizations at competitive disadvantage) 94 See Rensselaer, 79 T.C at 971-72 (with fieldhouse equally available for exempt or nonexempt purpose during idle time, actual-use allocation distributes expenses in proportion to use) 95 See DAVIDSON, HANDBOOK OF MODERN ACCOUNTING 18-10, 18-11 (1970) (straight-line depreciation is function of time allocating cost regardless of asset usage); I.R.C § 167(b)(1) (West 1984) (straight-line depreciation explicitly approved) 96 Rensselaer, 732 F.2d at 1062 97 Id Unlike any taxable business using a depreciation method based on time, an exempt organization allocating the fixed expenses of its dual-use facility on the basis of availability for use could not distribute any fixed expenses to the facility's idle time Id 98 See supra notes 48-53 and accompanying text (actual-use allocations satisfy requisite direct connection to unrelated activity as mandated by statute); supra notes 85-87 and accompanying text (with fieldhouse equally available for either exempt or nonexempt functions, actualuse allocations reasonable) 99 See supra notes 60-65 and accompanying text (actual-use allocation is reasonable accounting method which taxpayer has discretion to choose) 100 See supra notes 88-97 and accompanying text (actual-use allocations allow exempt organization to match taxable entities in allocating position of costs to idle time of assets, thus fulfilling legislative intent to eliminate unfair competition and Code inequities) 101 See supra note 25 (importance of potential precedential value reflected in filing of numerous amicus curiae briefs) 346 WASHINGTON AND LEE LAW REVIEW [Vol 42:333 and charitable organizations encounter in raising the necessary funds to maintain their level of service, such organizations will welcome the opportunity to save some of their limited resources by reducing their unrelated business income tax liability H F1_smIR IVEs .. .ALLOCATING FIXED COSTS OF DUAL-USE FACILITIES BY EXEMPT ORGANIZATIONS: ACTUAL USE OR AVAILABILITY FOR USE? The Internal Revenue Code of 1954 (Code) generally exempts certain nonprofit organizations... abuse of the tax exemption provided to charitable and educational organizations involved the acquisition of the nation's largest manufacturer of noodles for the benefit of the School of Law of New... Cir 1984) 1985] ALLOCATING FIXED COSTS Circuit addressed this difficult allocation problem, by considering what constitutes a reasonable basis for allocating the fixed costs of a dual-use facility.'